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Legal Liability of Auditors

Legal Liability of Auditors. Or, Sometimes Called the Malpractice Maze . Legal Liability of Auditors: A Historical Perspective. Before 1930: Few lawsuits 1930-1945: A number of precedent setting cases (Depression) 1945-1966: Few major lawsuits

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Legal Liability of Auditors

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  1. Legal Liability of Auditors Or, Sometimes Called the Malpractice Maze.

  2. Legal Liability of Auditors:A Historical Perspective Before 1930: Few lawsuits 1930-1945: A number of precedent setting cases (Depression) 1945-1966: Few major lawsuits 1976-1990: Many major lawsuits (Several Recessions) 2001 - ???? Many major lawsuits? Common Thread: Business Failures

  3. PrimaryPlaintiffs Clients Breach of Contract or Negligence 3rd Party Beneficiaries(Users of F.S.) Negligence Government Violate Security Laws or Negligence for Gov’t Insured Financial Institutions

  4. What is Negligence? • Ordinary Negligence:Violation of a Legal Duty to Exercise a Degree of Care that an Ordinarily Prudent Person (CPA) Would Exercise Under Similar Circumstances. • Gross Negligence:Reckless Disregard for Professional Responsibilities. How to Determine: • Reference to Professional Stds (GAAS) • CPA as an Expert Witness

  5. Most Likely Client Lawsuits • Late F.S. or Tax Returns • Failure to Find Fraud • Errors in Proposed F.S. Adjustments • Errors in Tax Returns • Disclosure of Confidential Info Result to Client: Usually A Loss Legal Basis: Common Law

  6. Client Must Prove • CPA Accepted Duty to Exercise Due Professional Care (Level of care should be included in the engagement letter - based on level of service.) • Breach of Duty (through negligence) • Client Suffered Loss • Loss Resulted from CPA’s Negligence

  7. 3rd Party Lawsuits • Basically an Inferred Breach of Contract. • 3rd Party Must be in Privity (Contractual Relationship) with the CPA. • Privity is Defined by Precedent Setting Cases and Varies by State. • Generally, there are 3-levels Defining Privity in terms of the Universe of Potential 3rd Parties Who Can Sue CPAs. • Some States Enacted Laws to Define.

  8. Required Proof Under Common Law 3rd Parties Plaintiffs Must Prove: • Loss Sustained • Auditor Was Negligent • 3rd Party Relied on the F.S. • F.S. Either Misleading or Had Misstatement Which is the Proximate Cause for the Loss. • Privity(as defined by state precedent or law)

  9. 3 Basics Approaches to Defining3rd Party Privity - Common Law • Ultramares Approach • Liable to Identified/Known Third-Parties

  10. 3rd Party Liabilities Under Common Law Ultramares Liable to knownspecific 3rd party like B of A for a specific purpose

  11. 3 Basics Approaches to Defining3rd Party Privity - Common Law • Ultramares Approach • Liable to Identified/Known Third-Parties • Restatement of Torts Approach • Liable to Foreseen Class(es) of Third Parties

  12. 3rd Party Liabilities Under Common Law Ultramares Liable to knownspecific 3rd party like B of A for a specific purpose Restatement of Torts Liable to known classes of 3rd parties like “banks” for a specific purpose

  13. 3 Basics Approaches to Defining3rd Party Privity - Common Law • Ultramares Approach • Liable to Identified/Known Third-Parties • Restatement of Torts Approach • Liable to Foreseen Class(es) of Third Parties • Rosenblum Approach • Liable to All Foreseeable Third Parties These apply for ordinary negligence. A CPA is liable to almost anyone for Gross negligence.

  14. 3rd Party Liabilities Under Common Law Ultramares Liable to knownspecific 3rd party like B of A for a specific purpose Restatement of Torts Liable to known classes of 3rd parties like “banks” for a specific purpose Rosenblum Approach Liable to all 3rd parties for normal business purposes

  15. Ultramares Approach to Auditor Liability Selected Cases Ultramares Corporation v. Touche (1931)--Landmark case under common law establishing auditors could be held liable to third-party beneficiaries for ordinary negligence and to other third parties for gross negligence. Credit Alliance Corp. v. Arthur Andersen & Co. (1985)--A common-law case establishing auditors must show knowledge of reliance on financial statements by a particular third party for a particular purpose to be held liable. Observation Auditors must have been aware that the financial statements were to be used for a particular purpose by a knownspecific third party to be liable to that party for ordinary negligence.

  16. Restatement of Torts Approach to Auditor Liability Selected Case Rusch Factors, Inc. v. Levin (1986)--A common-law decision in which the auditors were found liable for ordinary negligence to a third party not specifically identified to the auditors, although the auditors were aware of the intended use of the financial statements by this class of user. Observation To be held liable for ordinary negligence, the auditors must have been aware that the financial statements were to be used for a particular purpose, although the identity of the third party need not necessarily be known.

  17. Rosenblum Approach to Auditor Liability Selected Case Rosenblum v. Adler (1983)--Established that the auditors could be held liable for ordinary negligence to all third parties that the CPAs could reasonably foresee as users of the financial statements for routine business purposes. Observation Opens the door to liability for ordinary negligence to virtually all third parties who use the client’s financial statements for a normal business purpose (lending, investing, granting credit, acquisitions/mergers, etc).

  18. Approach Ultramares Restatement of Torts Rosenblum Parties Who May Recover for Ordinary Negligence Known 3rd party beneficiary Known class of intended 3rd party users Any 3rd party auditors could reasonably foresee as user Common Law Liability to Third Parties - Recap

  19. Securities Exchange Act of 1933 Applies to purchasers of securities (stocks & bonds) from the issuer. (Secondary purchasers can also use this act for up to one year after the registration statement.) Securities Exchange Act of 1934 Applies to purchases of securities from secondary sources. Primary Federal Securities Laws

  20. Civil Liability Under Federal Securities Laws What must be proved by 3rd party?Standard of Misleading Auditor ActLoss?F/S?Reliance? Liability 33 Act Yes Yes No Auditor must prove due diligence ___________________________________________________________ 34 Act, Yes Yes Yes Third party must prove Sec. 10 auditor scienter (intent to deceive, defraud, manipulate) 34 Act, Yes Yes Yes Auditor must prove Sec. 18 good faith (no gross negligence)

  21. Criminal Liability Under Federal Securities Acts Selected Case United States v. Simon (Continental Vending)(1969)--A highly publicized case in which auditors were held criminally liable for gross negligence. Two audit partners and a manager were convicted of filing false statements with a government agency, mail fraud, and violating Section 32 (a) of the Securities Exchange Act of 1934. This case also was largely responsible for the development of required disclosure of related party transactions (originally issued as SAS No. 6, and now contained in FASB Statement No. 57).

  22. Criminal Liability Under Federal Securities Acts Selected Case United States v. Arthur Andersen (2002)—Arthur Andersen was accused of the wholesale destruction of documents relating to the Enron Corporation collapse. The jury found, based primarily on an email message that an Arthur Andersen attorney advised a partner to revise a memo to omit certain information, including a comment that an Enron press release that included an earnings announcement was misleading. Loss of this case effectively put Arthur Andersen out of business. The conviction was overturned by the U.S. Supreme Court.

  23. Liability for “Unaudited” Financial Statements Selected Case 1136 Tenants Corporation v. Max Rothenberg and Company (1971)--A landmark case for accountants’ liability when they are associated with unaudited financial statements. The case demonstrated the importance of engagement letters to clearly establish an understanding with the client regarding the nature of the services to be provided. It also illustrated the need to follow up on unusual findings even when the CPAs are not performing audits.

  24. Preventing Litigation • Emphasize GAAS and professional ethics with staff. • Investigate prospective clients thoroughly. • Obtain a thorough knowledge of the client’s business. • Use engagement letters to prevent misunderstandings. • Carefully assess the risk of errors and fraud, including those indicated by weaknesses in internal control. • Exercise extreme care in audits of clients that have a high degree of business risk, as indicated by such factors as financial difficulties. • Carefully prepare and review working papers.

  25. To Improve Chances of Winning • Retain Legal Counsel Familiar With CPA’s Legal Liability. • Maintain Adequate Professional Liability Insurance - AICPA has a Group purchase Plan for Smaller Firms. (During all the lawsuits in the late 1980s and early 1990s, premiums skyrocketed so high that many smaller firms stop accepting audit engagements.)

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